Small Business Investment Corporation (SBIC)

Transaction

Group 4: Matthew Cormack, Carsten Cramer,

Nicolas Keller, Hajime Matsuura, Richard Quay,

Deborah Weiner, Maria Dolores Tejero, Sarah Tucker

I. Regulatory Background

II. Transaction Overview

III. Agreements

Small Business Investment Act (1958)

Allows a private equity firm which finances risky small business that are unable to obtain traditional bank financing to qualify as a Small Business Investment Company (SBIC) and receive government subsidies under the supervision of the Small Business Administration (SBA)

Small Business Investment Act (1958)

Small Business Concerns

Businesses which are independently owned and operated and are not dominant in their field of operation.

$0.5-$32.5 million in annual receipts

500-1,500 employees

Small Business Concerns

Financing Small Businesses

Equity Capital

Long Term Loans

Financing Small Businesses

Long-Term Loans

Strictly Regulated

Maximum interest rates, maturities and extensions

of maturity

Must be reasonably secured

Long-Term Loans

Transaction Overview

Acquisition

John Doe and Jane Doe want to cash out their investment in ABC, Ltd., a Texas company that produces “widgets.”

ABC, LLC buys the majority of ABC, Ltd.’s assets and assumes most of its liabilities.

ABC, LLC also buys John and Jane Doe’s intangible assets.

ABC, Ltd is liquidated.

Acquisition

Financing

ABC, LLC needs funds to pay for the assets.

Three SBICs provide ABC, LLC with two long-term loans.

In connection with the loans, the SBICs purchase warrants for stock in ABC, LLC.

Financing

The Sellers

ABC Company, Ltd., a Texas limited partnership

John Doe, CEO of ABC, Ltd and owner of Jo.Doe, LLC

Jane Doe, CEO of ABC, Ltd and owner of Ja.Doe, LLC

XYZ Investment Trust

The Sellers

The Purchaser

ABC, LLC, a Delaware limited liability company formed specifically for the purpose of acquiring ABC Ltd.’s assets.

The Purchaser

The Lenders

First Avenue Capital Corporation

First Avenue Capital II, LP

First Avenue Mezzanine Fund, LP

The Lenders

The Agreements

Asset Purchase Agreement1Employment Agreement

First Lien Loan Agreement

Intercreditor Agreement

Second Lien Loan Agreement

Limited Liability Company Agreement

Subordination and Intercreditor Agreement

Warrant to Purchase Stock

2

3

4

5

6

7

8

The Agreements

ASSET PURCHASE AGREEMENT

• Start-up operations in a new company

• New contracts with customers, suppliers and staff

• Buyer doesn’t take over risk on previous deliveries

• Seller is taxed on profit from the sold assets

• Buyer can depreciate purchase price for part of the assets

STOCK PURCHASE AGREEMENT

• Unchanged company number

• Company continues as before the sale

• Buyer takes over all “risks”

• Seller’s share profit is tax-free (deferred tax) in the holding company after three years’ ownership

• Buyer can not depreciate purchase price for the shares

Buyers Prefer APAs, Sellers Prefer SPAs

Start-up operations in a new company

New contracts with customers, suppliers and staff

Buyer doesn’t take over risk on previous deliveries

Seller is taxed on profit from the sold assets

Buyer can depreciate purchase price for part of the assets

Asset Purchase Agreement Unchanged company number

Company continues as before sale

Buyer takes over all risks

Sellers share profit is tax-free in the holding company after 3 year’s ownership

Buyer can’t depreciate purchase price for shares

Stock Purchase Agreement

Buyers Prefer APAs, Sellers Prefer SPAs

Asset Purchase Agreement

ABC, Ltd.Assets

John DoeJane Doe

ABC, LLC

Intangible Assets

$21 million cash$6 million ABC Note

400 Voting Units each

Asset Purchase Agreement

Ex-Ante Protection of the Investment

Adverse Selection: Sellers know more than Purchasers

about assets’ value

Moral Hazard: Sellers’ incentive to take care

of business diminished

APA 6: Representations and

Warranties

APA 6.10: Sellers will preserve

business

Ex-Post Protection of the Investment

Adverse Selection: Purchaser needs business to keep running as before

Moral Hazard: Sellers could behave

opportunistically

APA 8: John Doe will maintain ABC Ltd.’s

pre-existing business relationships

APA 8.6: Non-competition, non-

solicitation, non-disparagement

Adjustment of Purchase Price and Holdback

Adverse Selection: ABC, Ltd has more

info- purchase price may not be

accurate

APA 6.7:Representations and Warranties

Moral Hazard: ABC, LLC incentive to

manipulate closing balance figures

APA 4.2:Monitoring

Moral Hazard: Ensuring sellers

comply with post-closing covenants

Holdback amount makes it costly for sellers to behave inappropriately

ABC, LLC Needs John Doe’s Expertise and

Relationships

Employment Agreement

ABC, LLC makes John Doe CEO and furnishes

him with the information he needs to perform his duties

Safeguarding the Purchaser

Employment Agreement

Terminable at will

Non-Competition

Non-Solicitation

Non-Disclosure

Interest Alignment

Employment Agreement

Performance-Based

Compensation Structure

Loan Agreements

Lien Loan 1

$5,250,000

Lien Loan 2$16,500,00

0

First Avenue Entities

ABC, LLC

Loan Agreements

Information Asymmetries Entrepreneur’s main asset may be untested Basic competency may be unknown Viability of idea unknown

High Capital Costs for

Small Firms

High Capital Costs Pose Problems for

Lenders Difficult to calibrate with specific risks May attract firms with riskier business plans,

neglect firms whose risk is in their size May encourage borrowers to engage in

riskier projects with possibility of higher

returns

Restrictive Covenants

Secured against ABC, LLC’s assets

Strict limits on additional debt ABC, LLC can take on

Restricts sale of assets in which Lenders have interest

Restricts use of loan money

Minimum debt-to-earnings ratios

Lenders hold warrant to purchase 50% of ABC, LLC’s diluted equity

Interest Alignment:Creditors have been

granted security interest in same/overlapping

assets

Intercreditor Agreement

Creditors agree in advance on how to

manage their competing interests

in their common borrower

Moral Hazard: First lien creditors may not seek to maximize

sale price of the collateral

Second Lien creditors are put in watch-dog position to secure fair value transaction by first lien creditors.

Incentive Problem:

Risk that John Doe could divert ABC, LLC resources to ABC Note Holders at expense of Lien Holders

Potential self-dealing by junior creditors (John and Jane Doe) who are also equity holders in ABC, LLC

Subordination and Intercreditor Agreement

Payment of the ABC Note explicitly

subordinated to the first and second lien

loan debts

Mandate for double dividends

Member UnitsCapital

ContributionsPercentage

Interest

Fully Diluted Percentage

Interest

John Doe400 Voting

UnitsProperty valued at $1.2 million

50% 20%

Jane Doe400 Voting

UnitsProperty valued at $1.2 million

50% 20%

Additional Managemen

t

Up to 200 Non-Voting

Units--- --- 10%

TOTALS 1,000 Units $2.4 million 100% 50%

Warrant Holder

Units

First Avenue

Capital II, LP

20% Fully Diluted Equity Securities

50%

First Avenue Capital

Corporation

3% Fully Diluted Equity Securities

First Avenue

Mezzanine Fund

27% Fully Diluted Equity Securities

Ownership Structure

CEOSecretaryTreasurer

Management Structure

John Doe

3 ManagersFirst

Avenue Designe

e

John Doe

First Avenue Designe

e

2 Non-Voting First Avenue Observers

First Avenue Designe

e

First Avenue Designe

e

First Avenue Consent Rights

Certain actions of the Board may not proceed without the First Avenue managers’ approval:

Issuance of any equity securities

Redemption or repurchase of equity securities or voting units

Approval of any business plan or annual budget

Drag-Along Rights

Majority members (First Avenue) can force minority members to join in the sale of the LLC if the buyer is seeking to purchase all of the LLC’s interests

If the Board approves an acquisition transaction and First Avenue agrees, First Avenue has the right to cause all holders of units or securities to take all actions necessary to complete the transaction

Warrant to Purchase Stock

Gives holder the right but not the obligation to buy an underlying security

Issued directly by the company

Can be exercised at any time before expiry

Warrant Terms

Warrant to Purchase 400 Voting Units

10 Year Term

$0.01/Unit Exercise Price

FACIIABC, LLC

Potentially high return for very low exercise price.

Tax benefits.

Warrant term tacks to holding period for stock acquisition.